A manager has entered into 90 day forward contract to deliver 1,000,000 euros for dollar at 1.51/per USD . After 30 days the exchange rate is euro 1.58/per dollar. The risk free rate is 3% in Europe and 2.5% in US. Determine the value and direction of credit risk.
Euro depriciates so counterparty has the credit risk as manager might not honor his contract. This is one of my weakest sections and need to cover in next 25 days.
me too. Can anybody explain the calculations? I’m confused about PV of inflow-PV of inflow
Haven’t gone through the calcs yet, but both parties have risk… in crncy swaps, notional principal is exchanged at settlement so both have to make a delivery.
It is not swap but currency forward.
Ahh my bad. disregard…
Do you have a reference to the calculations you are referring to? CFAI Page etc? but in general if you are the manager (you are long the dollar) you have lossed around 29000, discounted at your risk free rate (2.5%) for two months. I think (i have not reviewed this section in some time).
Value of the manager = PV Inflows - PV Outflows PV Inflows = PV of cash flows to be received if he fulfills his obligation under the contract = CF / (1 + Domestic I) ^ T PV Outflows = PV of cash flows to be given up (the amount the manager could receive in the spot market) = CF / (1 + Foreign I) ^ T Value of the manager = (1,000,000 / 1.51) / [(1.025) ^ (2/12)] - (1,000,000 / 1.58) / [(1.03) ^ (2/12)] = 29,730.75913 Manager will be exposed to credit risk and the amount is 29,730.76. As far as why domestic interest is front, I don’t know. I will just remember this formula as it is.
Fwd -> 1,000,000 Euro = $662,251.65 1 Month into contract -> 1,000,000 Euro = $632,911.39 Credit Risk = [$632,911.39 / (1.03)^(1/6)] - [$662,251.65 / (1.025)^(1/6)] = $629,801.04 - $659,531.80 = -$29,730.76 Counterparty exposed.
rf040234, CardShark, You said that you remembered the formula. My q is that suppose here the manager is long dollars and short euros, wouldn’t be the formulas reverse? Which rate would you apply then? I want to understand this relationship.
In the case you mentioned, the manager is actually long dollars and short euros. However, if the manager is shorting dollars and longing euro. In other words, if A manager has entered into 90 day forward contract to deliver 1,000,000 dollars for euro at 1.51/per USD. After 30 days the exchange rate is euro 1.58/per dollar. The risk free rate is 3% in Europe and 2.5% in US. It will look like this. This time, the manager is located in Europe, so domestic interest rate is European interest rate. Value of the manager = PV Inflows - PV Outflows PV Inflows = PV of cash flows to be received if he fulfills his obligation under the contract = CF / (1 + Domestic I) ^ T PV Outflows = PV of cash flows to be given up (the amount the manager could receive in the spot market) = CF / (1 + Foreign I) ^ T Value of the manager = (1,000,000 * 1.51) / [(1.03) ^ (2/12)] - (1,000,000 * 1.58) / [(1.025) ^ (2/12)] = -70,931.64514 EURO This time, counter party (the person who longs USD) will be exposed to credit risk and the amount is 70,931.65. Hope this will help.
Remember the reason for the latter manager to be located in Europe is because he is in the hedging position. If he is longing EURO in the forward contract, he must be a Europe manager, because to hedge his foreign currency exposure he needs to long EURO. Hope this helps.
so what you do is stick to the formula but put in in the format you can relate to?
correct.
rf040234 Wrote: ------------------------------------------------------- > Value of the manager = PV Inflows - PV Outflows > > PV Inflows = PV of cash flows to be received if he > fulfills his obligation under the contract = CF / > (1 + Domestic I) ^ T > PV Outflows = PV of cash flows to be given up (the > amount the manager could receive in the spot > market) = CF / (1 + Foreign I) ^ T > > Value of the manager = (1,000,000 / 1.51) / > [(1.025) ^ (2/12)] - (1,000,000 / 1.58) / [(1.03) > ^ (2/12)] = 29,730.75913 > > Manager will be exposed to credit risk and the > amount is 29,730.76. > > As far as why domestic interest is front, I don’t > know. I will just remember this formula as it is. Despite of the formula, this result makes logic sense, manager deliver euro for US$. w/the original forward price Euro1.51/USD, manager will exchange more US$ , than the new market forward price Euro1.58/USD. Thus manager should have positive value on forward and bear credit risk .
this doesnt work here… Question no. 9, year 2009: it says that Maple Leaf is long a forward contract on EUR 50 million at 1.63 CAD/EUR, expiring in six months. current spot rate is 1.64 CAD/EUR then how can the counter party to this transaction can have the credit risk…maple leaf is long on the forward contract so they want to buy 50 million euros…the forward rate is 1.63…if the current spot rate is 1.64 wont maple leaf have the credit risk because they have to pay higher in the spot market… maple leaf is a canadian company
weirdo Wrote: ------------------------------------------------------- > this doesnt work here… > > Question no. 9, year 2009: > > it says that Maple Leaf is long a forward contract > on EUR 50 million at 1.63 CAD/EUR, expiring in six > months. current spot rate is 1.64 CAD/EUR > > then how can the counter party to this transaction > can have the credit risk…maple leaf is long on > the forward contract so they want to buy 50 > million euros…the forward rate is 1.63…if the > current spot rate is 1.64 wont maple leaf have the > credit risk because they have to pay higher in the > spot market… > > maple leaf is a canadian company weirdo, U have to discount the inflow and outflow amount by the EUR & CAD interest rate to get to the PV first, then compare: Value of the manager = PV Inflows - PV Outflows
I still do not get why it’s called outflow. The logic for inflow makes sense.
@james… maple leaf is long on a forward contract to buy 50 million euro… PV inflows = 1.63/(1.03)^0.5 Pv outflows = 1.64/(1.045)^0.5 pv inflows - pv of outflows=0.001786 but the CFA answer does it the opposite and gets a negative 0.001786…i want to understand why? generally its assumed that since maple leaf is a candian company it would want to sell 50 million euro for canadian dollars in the forward market to hedge the risk…in this case it would have made sense for the counterparty to have the credit risk…but here maple leaf is going long the euro…
weirdo Wrote: ------------------------------------------------------- > @james… > > maple leaf is long on a forward contract to buy 50 > million euro… > > PV inflows = 1.63/(1.03)^0.5 > > Pv outflows = 1.64/(1.045)^0.5 > > pv inflows - pv of outflows=0.001786 > weirdo, I think you have to switch between the inflows & the outflows up there. This PV inflows/outflows used to give me hard time as well. I finally had to read the notes 2, 3 times… Here is my process to this kind of Q. First, don’t pay too much attention at whether it is a Canadian co buying Euro; it can be a Mexican co. selling Euro for USD or Chinese co. buying USD with Peso. steps-- 1. Is the co. “selling” or “buying” a currency in a futures/forwards contract? 2. Solve the formula-- Value/payoff of the manager = PV Inflows - PV Outflows If buying a currency, Payoff = PV spot price - PV contract price (The co. is going to receive the market as revenue and pay the contract price as its cost) If selling a currency, Payoff = PV contract price - PV spot price (The co. is going to receive the contract price as revenue and pay the market as its cost) Hope this helps & feel free to discuss.